Thresholds effect of money growth and inflation in Rwanda: A nonlinear var model

Abstract

This paper estimated the threshold value of money growth and inflation as an early warning indicator for shifts in the inflation regimes, using quarterly data for Rwanda during the period 2007 to 2020. The Nonlinear VAR methodology allows us to capture possible nonlinearities such as asymmetric reactions to shocks and empirically test for changes in the relationship between money growth and inflation. The estimated threshold value is approximated at 15.3 percent for the money growth indicator (M3) in the case of headline inflation while the threshold value is equivalent to 17.1 percent on core inflation. The estimated values split the data into two regimes, the inflationary stressful episode, and the non-inflationary stressful episode. The findings revealed that switching from one regime to another regime provides a better signaling probability on the ex-post inflation that could be the basis of the forecast of the future path of inflation. We also presented the historical decomposition from the TVAR to the contribution of the four identified shocks on both cases of headline and core inflation. The overall results obtained support the view that money growth provides timely warning signals of transitions between inflation regimes. Thus, money growth provides an important early warning indicator to the risks of the departure of inflation from price stability.